Investors have been rewarded for holding a portfolio of UK growth funds with higher volatility over the past decade, according to research by FE Trustnet, which shows they have their outperformed less volatile peers in terms of total return.
Volatility has become synonymous with investing in financial markets of late thanks to a huge spike in 2016 as a consequence of bearishness also leaping up. This has largely been due to the slowdown in China’s growth rate, an apparent instability in its financial system and a sharp devaluation of its currency the Yuan.
This prompted investors to worry that deflation was an increasing risk, alongside slowing global growth, encapsulated in the ongoing rout in oil, gas and industrial commodity prices.
Not to mention the political uncertainty of the forthcoming Brexit referendum and subsequent US presidential election that could feasibly see the hugely controversial Donald Trump as the Republican nominee and eventual winner.
Warren Buffett (pictured), however, recently emphasised that volatility is an investor’s friend over the longer term. But how has this played for UK equity funds? 
In this study we examined in the IA UK All Companies sector at the 192 funds with a 10 year track record and constructed two portfolios. The first contains the top 10 per cent of most volatile funds (20 funds, equally weighted). The second contains the bottom 10 per cent of most volatile funds (20 funds, equally weighted)
According to FE Analytics, the more volatile funds’ portfolio has outperformed the less volatile funds portfolio over the past 10yrs by more than 2 percentage points. However both have outperformed the IA UK All Companies sector average and the FTSE All Share index by at least 30 percentage points.
Performance of portfolios, sector and index over 10yrs
Source: FE Analytics
It must be noted, however, that (unsurprisingly) the portfolio of funds with the highest volatility has delivered a greater maximum drawdown – which measures the most would have lost if they had bought and sold at the worst possible times – than the low volatility portfolio.
Over five and three year periods the more volatile portfolio has also outperformed, but over the past year the picture is less clear, as shown in the table below with a slight outperformance of the portfolio of lesser volatile funds.
Source: FE Analytics
Ben Conway, co-manager of the PFS Hawksmoor Vanbrugh and PFS Hawksmoor Distribution funds, highlights that there is a common thread running through the funds at the bottom and those at the top in terms of volatility.
“It’s not simply that the bottom ten per cent are run by poor managers and the top ten per cent by good managers,” he said.
“Ten years isn’t a sufficiently long enough time for these biases to have a neutral impact. For example, we all know that ‘bond proxies’ or companies with stable and steadily growing cash flows have been richly rewarded by the market over the past few years.”
Indeed, the lowest 10 per cent of funds in terms of volatility includes the likes of Invesco Perpetual High Income, Invesco Perpetual Income, Invesco Perpetual Income & Growth, Newton UK Opportunities and JOHCM UK Opportunities. They have tended to show a ‘quality bias’, holding stocks with strong income and cash-flow credentials.
There is also a strong showing of ‘special situations’ portfolios which look for value/contrarian or turnaround stories in their stock selection. These include Liontrust Special Situations, Investec UK Special Situations, Artemis UK Special Situations and Jupiter UK Special Situations. They tend to have lower correlations to equity markets than their peers.
The funds in the (outperforming) more volatile portfolio have two distinct themes. They are either mid cap or value orientated. With this portfolio a few funds have done extremely well (mid cap funds) and several have done quite badly (value) over 10 years.
The top performer in this portfolio include the likes of Franklin UK Mid Cap, Standard Life Investments UK Equity Unconstrained and Old Mutual UK Mid Cap.
The bottom performers include the likes of Dimensional UK Value, Old Mutual UK Alpha and Artemis Capital, which as the graph below shows are widely dispersed around the mean in terms of total return.
Performance of funds and portfolio over 10yrs
Source: FE Analytics
Conway adds: “In the same way you hear fund managers warn that past performance is not a guide to future performance, you can also say the same for volatility. And over long time periods volatility and asset price performance are usually negatively correlated.”
“It would be an interesting wager to see which set of funds will perform best over the next 10 years – I’d pick the set of funds in the bottom ten per cent for volatility. I suspect they will show lower volatility and better performance over the following 10 years than the set of funds in your top ten per cent table.”
Simon Evan-Cook, investment manager at Premier, is wary of using volatility in fund selection.
“Volatility is something we’re well aware of, but you have to be very careful in using it to guide investment decisions. Mainly because it’s based on the past, which as any good factsheet risk warning will tell you, is no guide to the future,” he said.
“We have bought funds in the past that looked like great prospects, but had recently been volatile. So we braced ourselves for a very bumpy ride, only to be pleasantly surprised that we got the good returns, but not the volatility. Buying UK smaller company funds following the financial crisis is the best example I can think of this.”
“Most recently, investors have had a lust for “lower-risk” equities, a.k.a. “bond proxies”. As businesses these are naturally less volatile, and as stocks they have recently proved less volatile as everyone is buying them, with very few selling.”
He adds, this doesn’t recognise ‘valuation risk’ has grown considerably in these stocks.
“There is also a risk of their volatility rising if buyers turn to sellers. So while we recognise and have benefitted ourselves from)good returns with lower volatility from these funds, investors need to be aware that they could provide lower returns with higher volatility going forward.”
Evan-Cook also adds investors also need to be aware that lower liquidity sometimes leads to lower volatility, but not lower risk.
“It is often higher, if anything. Commercial property funds, for example, looked like a gentle row on the millpond before the financial crisis. But as events subsequently showed, this was neither an indicator of good future returns, nor a sign of low risk.”
Conway also says he doesn’t use historic volatility when selecting funds.
“For us historic volatility tells you only very little about the riskiness of an investment. We believe risk is determined by valuation. Something that’s cheap is low risk, rather than something that has exhibited low volatility.”
“For example, although volatility is a statistical measure that is meant to be directionally agnostic, it is almost always the case that assets fall faster than they rise, i.e volatility rises as stocks fall and vice versa. If you were to pick an investment based on volatility alone, you risk buying the least volatile but most expensive.”
Steve Lennon, investment manager at Parmenion, meanwhile says his investment process has analysis of volatility at its heart as the team specifically look for funds which have demonstrated the ability to deliver above average returns together with lower volatility relative to the sector.
“We find that these funds may lag the sector in liquidity driven bull markets but tend to protect capital much better in a sell off. Over the medium to long term, the downside protection together with a more stable return profile ought to lead to relative outperformance.” 
Charles Stanley Direct’s Rob Morgan (pictured) meanwhile also says that while quality-biased funds have outperformed over the past year, and six months periods the higher volatile funds that focus on value may have been by sector specific problems.
“[The lower volatility funds] have avoided energy and miners to a large degree and so have delivered outperformance relative to both their peers and the index.”
“Value managers have, on the other hand, been led to these sectors due to the pricing of the stocks, possibly a little early, resulting in higher volatility and lower returns. It may be many of these funds have biases to particularly troubled sectors: mining, energy financials.
“Thus they have both suffered volatility and underperformed. Volatility often tends to be more associated with a falling price trend than a rising one.”
Ben Willis, head of research at Whitechurch securities looks at relative volatility between similar funds alongside other metrics.
“Volatility isn’t a bad thing – sometimes, you want a highly volatile fund as it may be high beta and so produce outperformance over time,” he said.